The Most Useless Question in Retirement Planning

No, I’m not planning to ask you out on a date. Nothing personal, but my wife has a South American temper and is definitely the jealous type.

Rather, I’m referring to the single most common question I see in retirement planning: “What’s your retirement number?” Said another way: what size nest egg do you need to quit working?

It sounds like a reasonable and straightforward question.

The problem is, it’s completely useless.

Like so many things in the financial planning business, the question takes something complex and full of nuance, and effectively dumbs it down to the point where it doesn’t mean anything. And that’s because it misses the bitter truth about retirement: you never know how much you’re going to need.

Think about it. Who wants to spend their golden years slowly depleting their nest egg hoping they don’t outlive it? No one wants to live out their best years that way!

Some say that to retire successfully you should multiply your final salary by a factor of 10. So if in your late 60s you expect to be earning $150,000, you’d need $1.5 million to retire.

But does that actually work? Using the standard “4% Rule,” which means you withdraw no more than 4% of your portfolio value per year, that would give you an annual income of $60,000. That might be just fine.

Or it might not.

What if you need more than $60,000 to pay your bills? What if the stock market has a major setback early in your retirement and your $1.5 million gets chopped down to $750,000 or less?

You might roll your eyes now, but that’s exactly what happened to millions of people that retired or were planning to retire during the last two bear markets.

The bigger, more fundamental problem with the “number” approach is this: it makes no consideration of market valuations or expected returns.

Let’s say stocks are cheap and priced to deliver returns of 10% per year or more. Taking out 4% per year in retirement would be perfectly prudent and reasonable.

But today, using common valuation metrics like the cyclically-adjusted price/earnings ratio (“CAPE”), stocks are priced to deliver returns of less than 1% per year. That means that even a 4% withdrawal rate risks depleting your nest egg early in retirement.

This is no way to plan for your golden years. It’s income that pays your bills, not a big ol’ fat nest egg full of assets. Focusing on an asset number rather than an income stream is like putting the cart before the horse.

If this were a raging bull market, this would matter a lot less. In that scenario you could reliably sell off assets along the way to meet your income needs. But in today’s market, that’s a risky proposition.

I’m not willing to leave my retirement to the whims of chance. Are you?

This is what I recommend you do…

Step #1: Grab a piece of paper. Write down a yearly income number you think you can live on in retirement. Try to be honest and reasonable and let your current monthly expenses be your guide.

Now, once you have that number… add 20% to it. You know as well as I do that expenses always seem to find a way of turning out to be more than you expected.

Step #2: OK, now that you have your “real” income number, start subtracting any “guaranteed” income sources. This includes things like Social Security or any pensions you have.

So, let’s say you need $100,000 to live every year (after adding in your 20% cushion). And let’s assume you expect to get $40,000 per year from Social Security, and another $20,000 from a private pension.

That just leaves you with $40,000 to come up with every year to meet your $100,000 goal. And that’s Step #3.

Of course, with bond yields scraping along near all-time lows, securing a safe $40,000 (or whatever the figure is for you) may seem easier said than done. But it’s really not difficult if you know where to look.

Some people prefer annuities. I’m really not their biggest fan as a savings vehicle, but as an income vehicle it’s an entirely different story. With an immediate annuity, you give a block of cash to an insurance company, and they in turn promise you a guaranteed monthly income for the rest of your life. Or, if you’re the “do it yourself” type, you can try a rental property or two.

But whatever’s left in your portfolio, have fun.

Take a little risk, or try an active trading strategy. With your basic income needs met, you can use any trading profits for little luxuries like travel or as gifts to your kids and grandkids.

I, for one, am planning a little getaway to the Dominican Republic later this spring. So your next Economy & Markets might be delivered on a post card.